Hedge Funds Step Into Repo Markets

Some of the largest hedge funds of the industry are stepping into the repo markets, reports Tracy Alloway and Arash Massoudi for Financial Times. Since banks have largely vacated the repo market after their risky practices led to the financial collapse of giants like Lehman Brothers in 2008, the space was open for new competitors.

The repo markets less attractive due to stricter rules

As traditional lenders are finding the repo markets less attractive due to stricter rules, large hedge funds are stepping in to fill the void. FT reports that big and famous names like Louis Bacon’s Moore Capital and Och-Ziff Capital Management Group LLC (NYSE:OZM) have been expanding their repo business, whereas broker Pierpont Securities is making a platform to pair up borrowers with suitable lenders.

Despite the regulatory changes that have tightened the hold on entities loaning assets in a repo market, risks are still evident. The recent unwinding in U.S. treasuries that drove yields close to 3 percent revealed the inherent problems of the more regularized repo markets of today. In the tri-party lending system, government-backed securities are offered as collateral by the borrower in exchange for short term loans from money market funds, insurers and mutual funds. When yields of USTs widened, the repo market suffered outflows of $187 billion. This fire-sale was reminiscent of what caused the collapse of the repo market during financial crisis.

The sentiment regarding hedge funds’ foray into this market is mixed; some believe that this can be a way for hedge funds to generate profits when interest rates are at near zero levels. Others think that in case of investment funds, it is not as easy to scrap profits from the repo business, because they would have higher costs of funding compared to banks.

Hedge funds and asset managers face less scrutiny compared to banks

One risk to the diversification in the repo market is that hedge funds and asset managers face less scrutiny compared to banks, therefore transactions in the business could become less regularized, presenting the same problem that shook the repo space five years ago.